Failure of democracy

Sept 6, 2020- Weekly comment

Paul McCulley is a legend in the financial industry.  Incredibly thoughtful, with brilliant depth of knowledge of economics and history woven into a grand worldview.  He was on an Odd Lots BBG interview with Joe Weisenthal and Tracy Alloway this week.  I am highlighting this interview because I believe it has bearing on how the Fed has been thinking about its new framework.  The quote that captured my attention is this:

“If the ideas that have worked over the last forty years work going forward, then democracy has failed.”

This was in response to Weisenthal’s question about whether a 60/40 investment split between equites and bonds was still relevant.  McCulley framed his response in the context of the broader investment and economic landscape.  I will quickly summarize how he reached his conclusion.

He started by saying that the last 40 years have been dominated by monetary policy, by the Federal Reserve, partially made possible due to that institution’s independence and technocratic decisions (“the adults in the room”).  Because of that, capitalism has dominated democracy.  He sees these two forces as somewhat incompatible but able to co-exist due to rule of law.  Capitalism is ruthlessly efficient, “win or lose based on smart or dumb” and has been heavily supported by monetary policy.   MonPol can be very efficient and can move quickly, in part because it’s separate from the sausage-making of politics.  Here is the crux of his argument: MonPol can’t channel support directly into main street, which he equates with democracy.  The Fed transmits its efforts through the banking system and monetary architecture which bypasses main street, thus exacerbating wealth inequality.  Financial assets have done well over the past 40 years due to a disinflationary backdrop.  However, when the economy arrives at the Zero Lower Bound (ZLB), the Fed must willingly become the partner of fiscal policy.  He says democracy has an inflationary bias, as politicians want to spend more than they tax.  (The Fed has the power to cut off that inflationary “fat tail”).   He further claims that capitalism has a DE-flationary bias, especially when abetted by the Fed, because capital triumphs over labor.  However, when the economy reaches the ZLB because the Phillips curve is flat as a pancake, then the Fed must become the subservient supporter of fiscal policy.  He says it unequivocally becomes the Fed’s job to “SAY YES” to larger fiscal deficits, in order to target wage growth.  In short the Fed must support fiscal efforts to shift the balance of power to LABOR over CAPITAL because labor represents democracy.  If it doesn’t, we’ve failed.

When I re-read my summary, I think it’s crazy.  It’s a roundabout defense of Modern Monetary Theory, and frankly, Stephanie Kelton does a much better job at explaining and supporting her proposals.  I think McCulley is brilliant, but he has rounded the bend with this one.  Not once does he mention the role of high tech with respect to its disinflationary impact, or for any other reason.  Not once does he mention demographics.  Not once does he mention the ramifications to general standards of living if his vision bears out.  He equates inflation with an increase in wages, an increase in wages benefits labor over capital, labor is Main St and capital is Wall St, the former is democracy and the latter is unfettered capitalism, therefore higher inflation is good.  Period.  The Fed can’t generate inflation when at ZLB, so it must serve the fiscal masters, which entails enormous deficits.  “Let the data tell us when we’re wrong.”

Allow me to briefly remove a step.  You’re wrong. 

Stephanie Kelton views an unwelcome overshooting in inflation as the limitation on her theory of MMT as well.  Wayne Gretzky is famous for saying.  “skate to where the puck is going, not to where it has been.”  I know and you know the puck bounces off the boards and sticks and skates.  I guess McCulley and Kelton see a flat sheet of ice with no walls and no opposing players, just flip the puck forward and it will frictionlessly glide forward towards an untendered goal.  Powell constantly refers to inflation expectations as a major determinant in actual inflation.  At least the Fed acknowledges walls and obstacles and possible second derivative ramifications. 

McCulley’s ideas represent a school of thought that has clearly influenced the Fed.  At Powell’s Jackson Hole speech he said the new framework statement will be informed by our “assessments of the SHORTFALLS of employment from its maximum level” rather than by “DEVIATIONS from its maximum level” as in our previous statement.  I.e. we’re fine with labor running hot.  It’s actually how the Fed has viewed stocks, and why there’s perception of an embedded Fed put: We react to a LOWER market but if it runs hot we’re all good.  Now the Fed is articulating some sort of labor/wage put.  Does that conversely imply that the Fed might now be a stock market CALL seller?  Hey, great timing Softbank!

It’s not that I personally don’t want to see labor gain in relation to capital.  I would applaud rebalancing.  I just don’t think government as it stands is likely to do a good job in effecting the transition.  In a country that is so rigidly divided along political faultlines, does It make sense to hand things off to the political class?  For either side?  About half the country will think any given policy is simply WRONG, whether it leads to inflation or not, (and there’s no guarantee that inflation equates to wage gains).  We are currently in a period which unambiguously requires more stimulus, and even now the parties aren’t able to agree on terms. 

Stephanie Kelton is sincere and convincing, and I believe there’s a good deal of sense in her argument, which is basically this:  ‘If deficits aren’t having an inflationary impact, doesn’t it make sense to run them in order to put people to work?  Let’s make the conversation about societal goals rather than how to pay for programs that aren’t generating inflation in any case.’   McCulley takes it a step farther and specifically advocates wage inflation and a shift in power to labor over capital.

About ten years ago I received a traffic citation, for which I appeared in court to contest, and lost.  The magistrate informed me that she was just sitting in and didn’t regularly work that jurisdiction, and that I could appeal her decision, which I decided to do.  I went to the imposing fortress known as Chicago City Hall, with its magnificent limestone pillars of justice, to file my appeal and request a new date.  The operative word, in this case, was not “justice” but “file”.   I was directed to an office on the fourth floor, and pointed to a desk in a vast room that consisted of long counters fronting endless rows of old metal filing cabinets and inquired as to how to file my appeal.  You get the picture, an oscillating fan in the corner gently rustling papers as it made its sweep of the realm.  The woman behind the counter was a sharply dressed middle-aged black woman, friendly and helpful, who handed me a ballpoint pen and the forms to fill out, and charged me the fee.  “Make sure you press hard on those forms honey, because there’s four sheets with carbon paper and we need to make sure we can read the bottom page.”  What could I do besides smile (and press hard)?  CARBON PAPER.  FILING CABINETS.  I’m not going to make the generalization that Chicago City Hall represents democracy and labor in a larger sense.  I will however, venture to say that a dollop of capitalistic technology to move things along can be helpful.  End result, after another experience (like a Kafka novel) of sitting in a crowded court awaiting the judge, who came in and suggested that anyone who wanted to avoid an additional delay could pay their fine and have court costs refunded could do so, I got up, paid my $250 and walked out into the warm summer morning in the City that Works.     

Just a couple of anecdotal notes to wrap up this section.  First, Friday’s employment report included yoy wage growth of 4.7% (Avg Hourly Earnings).  The growth in wages this year has been higher by far than any other year in the past ten.  Second, even with stocks falling on Thursday and Friday, bonds (TYZ, USZ, WNZ) had their lowest settlement of the week on Friday.  Many analysts have commented that these yield levels provide no measure of protection if stocks falter.  So maybe McCulley is right and we’re NOT looking at the inevitable failure of democracy:  wages are going up and 60/40 isn’t working. 


This week starting Tuesday, treasury auctions $108 billion, of which $87 billion is new cash: Tuesday $50b in 3’s, Wed $35b in 10s and Thursday $23b in 30’s.  On Tuesday the Fed is buying $1.75b in 20-30 yr treasuries and on Friday, $6 billion of 4.5 to 7 yr treasuries.  Also during the week, the Fed will buy over $21 billion in 15-30 yr MBS/agencies. 

On the week ending Friday August 28, many measures of the curve closed at or near new highs for the year.  For example, 5/30 had ended at 123.4 bps on 8/28.  By the middle of last week, gains had evaporated, with 5/30 back down to 110 on Thursday.  However, on Friday, steepening again took hold, and 5/30 ended at just over 116.  2/10 closed the week at 56.7 down just 2.6 from the previous Friday’s close.  On the Eurodollar curve, some of the nearer calendar spreads actually closed higher on the week.  As an example, EDZ’21/EDZ’22 which had been bought in good size at 3.5 a couple of weeks ago, closed 5.5 on Friday, up 1 on the week.  The short leg of this calendar, EDZ’22, had seen additional pressure in the previous week with a buy of 125k 2EZ 9962/9950ps for 2.5 (ref 9973).  This week that put spread settled 2.5 vs 9970.5. 

One other note that I find quite interesting.  Over the past few years, aggregate open interest in the Ultra-bond WN contract exceeded that of the classic bond (US).  This year, that relationship has changed.  In 2019, WN hit a peak OI of 1.28 million but averaged around 1.2.  US, by comparison, averaged around 1 million.  However, this year in late Feb when WN spiked to 1.375 million, US surged to 1.49.  Over the active life of the Sept contracts (June to end of August), US steadily increased from 1 million to 1.2.  WN did the same, but the surge was only during the calendar roll.  Since the roll, WN dropped back down to 1.001m contracts, while US remains relatively high at 1.147m.  I attribute this change to the fact that ultras never developed an option market, and the US contract is seeing renewed interest in option activity/hedges (as had been predicted by option market maker RK, thanks).  There is virtually no open interest in WN options.  Bond vol has also been the strongest thing on the board.  Dec treasury options expire 20-Nov, after the election.  Current DV01 on USZ0 is $215 for one contract.  Shorter term historical vol measures are now catching up to Dec implied, which may have implications for the shape of the curve. 

UST 2Y13.314.91.6
UST 5Y27.430.12.7
UST 10Y72.671.6-1.0
UST 30Y150.8146.3-4.5
GERM 2Y-66.5-70.0-3.5
GERM 10Y-40.9-47.2-6.3
JPN 30Y61.760.6-1.1
EURO$ Z0/Z1-7.0-5.02.0
EURO$ Z1/Z24.55.51.0
EURO$ Z2/Z313.514.00.5
CRUDE (active)42.9739.77-3.20

Posted on September 6, 2020 at 12:29 pm by alexmanzara · Permalink
In: Eurodollar Options

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